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How Europe could avoid America's mistake

In case you missed it over the Thanksgiving long weekend, TheNew York Times ran a great column by Chrystia Freeland highlighting how Chicago Booth Finance Professor Amir Sufi’s innovative research on UShousehold debt levels (which we covered in depth back in the October 2012 issue of Capital Ideas magazine) holds important lessons for Eurozone policymakers.

On the same day, the Washington Post rang a long analysis piece by Zachary Goldfarb that also depended heavily on research by Sufi, who has shown that the financial crisis hit poorest households the hardest: while the wealthiest 10 percent of households have seen little decline in their wealth, the wealth of those in the middle and the bottom—many of whose only significant financial asset is their homes—has reduced dramatically. Goldfarb followed up his Post analysis with a good, chart-heavy blog post using Sufi’s charts illustrating this point.

This has held back US consumer spending. As Goldfarb noted in the Post, Sufi’s research (conducted with co-author Atif Mian from Princeton) reveals that the most indebted areas of America significantly dampened consumer spending in the years leading up to, and into, the crisis:

“People who owed huge debts when their home values declined cut back dramatically on buying cars, appliances, furniture and groceries. The more they owed, the less they spent. People with little debt hardly slowed spending at all ... From 2006 through 2009, overall consumer spending was flat, according to calculations Sufi completed for The Washington Post. But among the quarter of U.S. counties with the highest debt, it fell 5.5 percent. Without that hit, spending nationwide would have increased by 2.4 percent.”

While it’s dangerous to link such a long-term, structural story to ephemeral data, official figures out today would seem to confirm that while U.S. consumer confidence generally seems to be on an upward trend, growth in consumer spending remains fragile. Americans cut their spending in October (by a seasonally adjusted 0.2 percent) for the first time in five months, according to the Commerce Department. Of course, Hurricane Sandy is part of the explanation, but even discounting the storm, the report was disappointing, especially after September’s increase of 0.8 percent. It came a day after third-quarter consumer spending growth was revised down to 1.4 percent from 2 percent, the smallest increase in more than a year.

Freeland noted that the policy implications of Sufi’s work go beyond the well-worn debate between Keynesians who advocate that the correct response to lackluster economic growth is more stimulus and free-marketeers urging that state spending be slashed. Sufi suggests that in the U.S., stimulus has been misdirected: if they want to promote consumer spending, governments should think about targeting bailouts to distressed homeowners rather than bankers.

Freeland wrote:

“Mr. Sufi thinks it is probably too late to jump-start the U.S. economy by helping its less well-off homeowners. But he believes the United States' missed opportunity holds an important lesson for Europe. The U.S. mistake, in Mr. Sufi's view, was to give political priority and financial support to credit-holders -- the banks -- while ignoring the distress of debt-holders. He thinks Europe is repeating that error.
“In Europe, as in the United States, the creditors, led by Germany, have overwhelming political power. But they may be winning a Pyrrhic victory -- as in the United States, when debtors are hammered too hard, it is tough for the overall economy to grow.”